Etfs: Risky Business And Why You Shouldn't Invest

Exchange-traded funds (ETFs) are a popular investment vehicle for both active and passive investors. They are similar to mutual funds but trade like stocks, allowing investors to broaden the diversity of their portfolios without increasing the time and effort spent on managing and allocating their investments. However, there are several reasons why one might choose not to invest in ETFs. Here are some of the drawbacks of investing in ETFs:

- Commissions and Expenses: ETFs trade like stocks, and investors may have to pay a commission every time they buy or sell, which can quickly add up and reduce investment performance. While some brokers offer zero-commission trading, there may still be hidden costs in the form of payment for order flow (PFOF). Additionally, ETFs come with expense ratios, which, while typically low, can vary and impact overall returns.

- Underlying Fluctuations and Risks: Just because an ETF offers diversification across multiple underlying positions doesn't make it immune to volatility. The potential for large swings depends on the scope of the fund. ETFs that track specific industries or sectors can be more volatile than those tracking broad market indexes.

- Capital Gains Distributions: In some cases, ETFs distribute capital gains to shareholders, creating a tax liability for the investor. Reinvesting these distributions incurs additional fees.

- Lack of Downside Protection: ETFs that track stock market indexes, such as the S&P 500, will expose investors to the full downside risk of the market during corrections and crashes.

- Lack of Reactive Ability: Index investing does not allow for advantageous behaviour. If a stock becomes overvalued, it carries more weight in the index, but this is when investors would typically want to reduce their exposure.

- Complexity: Some ETFs, especially those based on commodities or derivatives, can be complex and may not perform as expected. For example, an oil ETF may hold oil futures rather than the physical commodity, leading to potential underperformance relative to the price of oil.

- Temptation to Trade: The wide variety of ETFs available, including those that track market volatility or sentiment, can tempt investors to speculate and treat investing more like a table game than a discipline.

- Limited Control: Investors in ETFs do not have a say in the individual stocks included in the underlying index, limiting their ability to exclude companies they wish to avoid for moral or personal reasons.

ETFs may be subject to high trading fees

As with stocks, every time you buy or sell an ETF, you may have to pay a commission. Depending on how often you trade an ETF, these trading fees can quickly add up and reduce your investment's performance. For example, if you are investing $200 per month or rebalancing a $5,000 Roth IRA, you may want to consider searching for no-fee ETFs.

No-load mutual funds, on the other hand, are sold without a commission or sales charge, making them relatively more advantageous than ETFs in this regard. It is important to be aware of trading fees when comparing an investment in ETFs with a similar investment in a mutual fund.

Many online brokers today offer zero-commission trading in stocks and ETFs. However, you may still pay a hidden commission in the form of payment for order flow (PFOF). This controversial practice routes your orders to a specific counterparty rather than having the market compete for your order at the best price possible.

Actively trading ETFs, as with stocks, can reduce your investment performance as commissions quickly pile up.

ETFs can be illiquid

Liquidity is a significant consideration when investing in ETFs. Liquidity refers to the ability to buy or sell an investment without significantly impacting its price.

Some ETFs are thinly traded, meaning there may be issues with exiting the investment, depending on the size of your position relative to the average trading volume. The biggest sign of an illiquid investment is large spreads between the bid and ask prices. Tighter spreads indicate greater liquidity and reduced risk when entering and exiting trades.

ETFs with low liquidity may result in wider bid-ask spreads, reduced opportunity to trade profitably, and, in extreme cases, an inability to withdraw funds in certain situations, such as a significant market crash.

To avoid liquidity issues, investors should study the spreads and market movements of an ETF over a week or month before investing.

ETFs may be too complex

ETFs may seem simple and efficient compared to traditional funds, but some are far more complex. This complexity relates to what the ETF owns. For example, if you want to buy gold or silver, you can buy ETF shares that represent holdings of the physical, underlying commodities. However, if you want to buy an oil ETF because you believe the price of oil will go up, it is likely that your ETF will hold oil futures, not the physical commodity. This is a fundamental difference, often misinterpreted as a minor nuance, and has led to many disappointed oil ETF owners who have experienced historical underperformance relative to the price of oil.

ETFs can be composed almost entirely of derivatives, which can be complex and difficult to understand. As Larry Swedroe, principal of Buckingham Asset Management and co-founder of BAM Advisor Services, says, "If you don't understand an investment well enough to explain it to a fifth-grader, don't buy it."

ETFs can also be complex because they are not actively managed. While this passive management style can reduce costs, it means that a manager cannot sell out of positions before capturing an entire market crash. Although not every active manager can do this, many can, and this may be an argument for the use of actively managed funds.

Additionally, ETFs can be complex because they are not all created equal. Some ETFs are more thinly traded, and these ETFs are more likely to have pricing issues and be subject to mispricing during periods of market volatility. It is important for investors to understand what they own and what an ETF could return, as not all ETFs are the same.

ETFs can tempt investors to speculate

ETFs have become increasingly popular, and for good reason. They are a great way to invest in a diverse range of assets without having to spend too much time and effort on research and management. However, one of the downsides of ETFs is that they can tempt investors to speculate.

ETFs are often marketed as a simple, passive investment strategy. However, the wide variety of ETFs available can lead to investors purchasing ETFs that are overly complex and speculative. For example, investors can purchase ETFs that track not only markets but also market volatility, sentiment, or momentum. There are also inverse ETFs that allow investors to short (bet against) a particular market. Additionally, some ETFs use derivatives and debt to amplify the returns of the underlying index, which can lead to significant losses if the ETF is held for a long time.

The ease of investing in ETFs and the wide range of options available can lead to investors treating investing more like a game than a disciplined process. It can also lead to investors taking on more risk than they are comfortable with or losing sight of their long-term investment goals.

To avoid the temptation to speculate, investors should remember that ETFs are meant to be a long-term investment and should be treated as such. Investors should also ensure they understand what the ETF actually owns and how it is managed. It is important to remember that just because an ETF is marketed as a certain type of fund (e.g. an oil ETF) does not mean that it actually holds the physical commodity. Finally, investors should ensure that they are comfortable with the level of risk associated with the ETF and that it aligns with their investment goals and risk tolerance.

ETFs may not align with your values

ETFs are a popular investment vehicle, but they may not always align with an investor's values or financial goals. Here are some reasons why:

Lack of Control and Alignment with Values

Investors in ETFs typically do not have a say in the individual stocks included in the fund's underlying index. This means that if an investor wants to avoid a particular company or industry due to moral or ethical conflicts, they may not have the same level of control as they would when investing in individual stocks. For example, an investor concerned about environmental issues may want to avoid companies with a negative environmental impact, but an ETF might include such companies in its portfolio.

Complex and Gangly Nature

Some ETFs can be overly complex and gangly, especially when it comes to what the ETF actually owns. For instance, an oil ETF might hold oil futures instead of the physical commodity, leading to potential underperformance relative to the price of oil. This complexity often goes unnoticed, resulting in disappointed ETF owners.

Temptation to Trade and Speculate

The wide variety of ETFs available can tempt investors to speculate and trade frequently. While ETFs can provide adequate diversification, they also tempt investors to venture into speculative areas, such as market volatility, sentiment, or momentum. Inverse ETFs, which bet against a particular market, and leveraged ETFs, which can double or triple that bet, turn investing into more of a gamble than a disciplined strategy.

Limited Capital Gains Tax Advantage

ETFs can be more tax-efficient than mutual funds, reducing exposure to unintentional taxable events. However, this advantage primarily applies to taxable accounts. In tax-privileged accounts, such as retirement accounts, the tax benefits of ETFs may not be as significant.

Underperformance Compared to Active Management

While ETFs offer low costs and diversification, they may underperform actively managed funds in certain investment categories. Active management allows fund managers to sell out of positions before capturing an entire market crash, which is not possible with passive ETF strategies. Additionally, active managers can add value by loading factors such as beta, size, value, profitability, and momentum, further enhancing returns.

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